Journal of Accounting and Economics 9 (1987) 7-34.

North-Holland

THE EFFECT OF ACCOUNTING PROCEDURE CHANGES ON

CEOs’ CASH SALARY AND BONUS COMPENSATION*

Paul M. HEALY and Sok-Hyon RANG

Sloun School of Management. MIT, Camhrdgr, MA @l_W, b’SA

Krishna G. PALEPU
Ilaruard Busmess School. Boston. MA k?163. (I’sA

Received November 1985. final version received October 1986

This paper examines the effect of accounting procedure changes on cash salary and bonus
compensation to CEOs. We estimate whether there is an adjustment to the statistical relation
between compensation and corporate earnings following changes that lower earnings (FIFO to
LIFO inventory valuation) and that raise earnings (accelerated to straight-line depreciation). The
results indicate that (1) subsequent to these changes salary and bonus payments are based on
reported earnings, rather than earnings under the original accounting method, and (2) the
potential compensation effect of the changes is small compared to the elfect of economy- or
industry-wide changes in compensation.

1. Introduction
In many large U.S. corporations, executives’ remuneration is explicitly
linked to reported earnings. For example, in 1980 more than 90 percent of the
1000 largest U.S. manufacturing companies used some form of earnings-based
compensation plan [see Fox (198O)J.l Recent studies in accounting hypothesize
that these earnings-based plans induce managers to select income-increasing
accounting procedures, or impede their selecting income-decreasing proce-
dures, since compensation is imperfectly adjusted for the effect of alternative

*We wish to thank Andrew Christie, Dan Collins (the referee). Linda DeAngelo. Michael
Jensen, Bob Kaplan Rashad Abdel-khahk, Pat O’Brien, Rick Ruback. Ross Watts, Jerry
Zimmerman, and the participants at the Stanford Summer Workshop and the MIT Accounting
Workshop for their helpful comments on earlier drafts of this paper. We are also grateful to Bob
Holthausen and Richard Rikert for letting us use their data bases of changes in accounting
procedures.
‘The most popular schemes included bonus and performance plans. Bonus plans typically
award managers cash payments if certain annual earnings targets are attained: performance plans
award managers the value of performance units or shares in cash or stock if certain long-term
(three- to five-year) earnings targets are achieved. For a more detailed description of bonus plans,
see Healy (1985). For a description of performance plans. see Smith and Watts (1982) and Larcker
(1983).

0165-4101/87/$3.50 c 1987, Elsevier Science Publishers B.V. (North-Holland)

8 P. Ifw!v. S. Kong und K. Palepu, Accounting procedure chunges und CEO compensutm~

accounting methods. [See Holthausen and Leftwich (1983) and Watts and
Zimmerman (1986) for a summary of these studies.]
This paper examines the statistical relation between cash salary and bonus
remuneration to chief executive officers (CEOs), and corporate earnings. We
test whether there is an adjustment to this statistical relation subsequent to an
accounting procedure change. Two forms of adjustment are considered: (1)
those that transform reported earnings under the new accounting method to
earnings under the original method, and (2) adjustments to the parameters of
the relation that offset the effect of the accounting change. We also examine
the effect of an accounting change on CEOs’ salary and bonus awards if no
adjustment is made to either reported earnings or parameters of the compensa-
tion-earnings relation.
We investigate two accounting method changes: from the FIFO to LIFO
inventory method, and from accelerated to straight-line depreciation.2 These
are selected for the following reasons. First, they have a large effect on
reported earnings. Second, FIFO to LIFO switches typically decrease reported
earnings, whereas changes from accelerated to straight-line depreciation usu-
ally increase reported earnings.j By investigating both income-increasing and
income-decreasing changes we are able to increase the power of our tests. Our
inventory sample comprises 52 test firms that changed from the FIFO to
LIFO inventory method and 50 control firms with no inventory or deprecia-
tion method changes. The depreciation sample contains 38 test firms that
changed from accelerated to straight-line depreciation and 37 control firms.
We conclude that (1) subsequent to the accounting changes, cash salary and
bonus awards are based on reported earnings rather than ‘as-if’ earnings; (2)
the parameters of the compensation-earnings relation change for both the test
and control firms subsequent to the accounting changes: and (3) the potential
impact of the method changes on salary and bonus payments is small relative
to economy-wide changes in compensation.
A number of earlier studies have examined the relation between inventory
and depreciation accounting method changes and executive compensation.
Their results are mixed. For example, Holthausen (1981) investigates whether
the cross-sectional variation in firms’ abnormal stock price performance at the
date of a change from accelerated to straight-line depreciation is related to the
existence of an earnings-based compensation plan. No relation is found.

‘A number of earlier studies that investigate the stock price reaction to accounting changes also
focus on these two changes, They include Kaplan and Roll (1972) and Holthausen (1981) in the
case of depreciation changes, and Sunder (1973,1975), Biddle and Lindahl (1982) and Ricks
(1982) in the case of inventory changes.
‘Changes from FIFO to LIFO decrease reported earnings if input prices are rising and physical
inventory levels are not depleted. Changes from accelerated to straight-line depreciation increase
reported earnings if nominal investments in new depreciable assets are increasing.
 P. Heu(v, S. Kung and K. Palepu, Accounting procedure changes und CEO compemut~on 9

However, as Holthausen and Leftwich (1983) point out, this test lacks power
because the compensation effects of accounting changes are likely to be small
relative to the variability in stock prices and, it is difficult to identify the event
dates and specify investors’ expectations. Hagerman and Zmijewski (1979)
investigate whether companies that have earnings-based compensation plans
are more likely to use the FIFO inventory method and straight-line deprecia-
tion than companies with no earnings-based plans. They find no relation
between the cross-sectional variation in inventory methods and the existence
of a compensation plan. However, there i s 0 !veak positive relation between
the probability that a company uses straight-line depreciation and the prob-
ability that it has an earnings-based compensation plan.
Abdel-khalik (1985) estimates a cross-sectional regression of salary and
bonus compensation on earnings for a treatment sample of 88 companies that
changed to LIFO in 1974, and a control sample of 88 companies that
remained on FIFO in that year. He estimates differences in the fixed compo-
nent of compensation and the elasticity of compensation to reported earnings
between these two samples in the two years prior to, the year of, and the year
following the accounting change. In the two years prior to the inventory
change the compensation parameters do not differ between the treatment and
control groups. In the year of the change, the fixed component of compensa-
tion is higher for the control group and the elasticity of compensation to
reported earnings is higher for the treatment group. These differences persist
when reported earnings are replaced by as-if FIFO earnings for the treatment
group. Abdel-khalik’s findings are therefore mixed.
Our test design differs from that of Abdel-khalik in three ways. First, we
examine two accounting changes, one that typically increases earnings (a
change to straight-line depreciation) and another that decreases earnings (a
change to LIFO). Second, our tests examine earnings and compensation data
for as many as ten years following an accounting change. Third, we use a
time-series rather than a cross-sectional approach to estimate the relation
between compensation and earnings. Murphy (1985) points out that studies
that regress compensation on some index of performance across executives at
a particular point in time are likely to be misspecified. For these regressions,
‘the exclusion of individual-specific factors, such as education and training,
perceived ability, performance in previous jobs, firm size, etc., will lead to an
omitted variables problem, reflecting factors that are fixed for an executive
over time but vary across executives at a point in time’ (p. 22). Correlations
between the independent variables in a cross-sectional regression and these
omitted variables will bias the estimated coefficients. There is some evidence
that Abdel-khalik’s findings suffer from this form of misspecification because
when firm size is included in his cross-sectional regressions, the fixed compo-
nent of bonus and salary awards and the elasticity of compensation to
earnings no longer differ between the treatment and control groups.
10 P. Heu(r’. S. Kong and K. Pdepu, Accounting procrdurechanges and CEO compensu~mn

The remainder of the paper is organized as follows. Section 2 describes the

sample selection and data collection. The statistical tests and results are
presented in section 3, and our conclusions are discussed in section 4.

2. Sample selection and data collection

The sample of inventory changes is selected from Accounting Trends und

Techniques (1970 to 1976). We identify 161 companies that changed from
FIFO to LIFO during this period. Our sample of depreciation changes is
selected from Holthausen’s database [see Holthausen (19Sl)J. We exclude
companies that changed to straight-line depreciation prior to 1967 since
compensation data for these companies are incomplete. This restriction limits
our sample to 80 of Holthausen’s 139 companies.
Bonus and salary data and management changes are collected for the CEOs
of our sample companies for the year of the accounting change and the ten
years before and after that event from two sources: corporate proxy state-
ments and the annual compensation survey published by Business Week. We
require that (i) at least five years of consecutive compensation data are
available before and after the year of the accounting change, and (ii) a
minimum of 14 consecutive years of data are available for each company.
These data constraints reduce the test samples to 52 companies that changed
inventory policies and 38 companies that changed depreciation methods. The
distribution of the changes over the sample period is reported in table 1. The
depreciation changes are clustered in 1968 and 1969, and the inventory
changes in 1974 and 1975.
Table 2 presents the 2-digit industry breakdown for the test firms. There is
some evidence of industry clustering: 23 percent of the firms changing
inventory method are in the chemicals industry (SIC 28) and 47 percent of the
firms changing depreciation method are in the primary metal industries (SIC
33) and the machinery industry (SIC 35). To control for this industry cluster-
ing we collect a matched sample of control firms. The control firms are
required to have the same 2-digit industry code as their test firm matches, to
have had no inventory or depreciation method changes ten years before and
after the years of their test firms’ method changes, and to satisfy the com-
pensation data constraints imposed on the test sample. Fifty control firms are
found for the inventory sample, and 37 firms for the depreciation sample. The
two inventory test firms with no matched control firms available are in the
stone, clay, glass and concrete products industry (SIC 32). The one deprecia-
tion test firm with no matched control firm available is in the machinery
industry (SIC 35). The inventory and depreciation control samples are not
independent - 20 of the companies used in the inventory control sample are
also included in the depreciation control sample.
Earnings before extraordinary items are collected from COMPUSTAT for
the test and control samples for each year that compensation data are
 P. Ileu!v, S. Kmg ard K. Palepu. Accountingprocedure chmge.~ und CEO compensatm 11

Table 1
Number of test firms changing to LIFO or straight-line depreciation by year in the period
1967-1976.

Number of firms
Year of Number of firms changing to straight-
accounting change changing to LIFO line depreciation

1967
1968
1969 _
1970 1
1971 1
1972 0
1973 0
1974 36
1975 10
1976 4
Total 52

Table 2
Number of test firms changing to LIFO or straight-line depreciation in the period 196771976 hy
2-digit industry

Number of firms
2-digit changing to
SIC Number of firms straight-line
code Industry changing to LIFO depreciation

20 Food products
21 Tobacco manufacturers
22 Textile mill products
23 Apparels and fabric products
26 Paper and paper products
28 Chemicals
29 Petroleum refining
30 Rubber and misc. plastic products
31 Leather and leather products
32 Stone, clay, glass and concrete products 2
33 Primary metal industries 9
34 Fabricated metal products, except
machinery and transportation equipment 1
35 Machinery, except electrical 4 9
36 Electrical and electronic machinery.
equipment and supplies 4
37 Transportation equipment 5
38 Measuring, analyzing. and controlling
instruments. photographic. medical and
optical goods, watches and clocks 1
39 Miscellaneous manufacturing industries 1
51 Wholesale trade-nondurable goods 1
53 General merchandise stores 3 1
54 Food stores 2 1
59 Miscellaneous retail stores 1
Total 52 38
12 P. Heui,~. S. Kmg md K. Palepu, Accoun~rng procedure changes md CEO con~permtron

Table 3
Summary statistics for average annual executive cash salary and bonus, and corporate earnings for
sample firms.”

Mean
standard First Third
Mean deviation quartile Median quartile

A ueruge execufiue sulcr~y i honush

Inventory:
Test sample’ 200 49 160 194 234
Control sample’ 169 40 127 168 206
Depreciation:
Test sample 176 44 134 17x 209
Control sample 165 41 130 165 1x5
Aoeruge corporate earnings’

Inventory:
Test sample 116,216 47,786 26.312 52.233 89,694
Control sample 73.078 30.495 5.747 36.067 76,179
Depreciation:
Test sample 52,308 21.293 15,032 3 1,247 67.877
Control sample 57,736 29,881 14.007 34,395 49.920

“These results are for the cross-sectional distribution of time-series averages of annual executive
cash salary and bonus, and corporate earnings for each firm in the inventory and depreciation
samples, Each time-series contains between 14 and 21 observations.
‘Both executive salary and bonus, and corporate earnings are in thousands of CPI-deflated
(1967 = 100) constant dollars.
‘The test sample comprises 52 firms that change to LIFO in the period 1970-1976 and 38 firms
that change to straight-line depreciation in the period 1967-1974. Each test Arm has a matched
control firm with the same 2-digit SIC code and with no inventory or depreciation method
changes ten years before and after the year of the test firm’s method change. Control tirms are
found for 50 of 52 inventory test firms and 37 of 38 depreciation test firms.

available. Compensation and corporate earnings data are deflated by the CPI
to 1967 dollars and time-series averages of these variables estimated for each
company. A summary of the cross-sectional distribution of these time-series
averages is presented in table 3. The median average salary and bonus in 1967
constant dollars is $194,000 for the inventory test sample and $168,000 for the
inventory control sample. The median values for the depreciation test and
control samples are $178,000 and $165,000, respectively. The median average
corporate earnings in 1967 dollars is $52,233,000 for the inventory test sample
and $36,067,000 for the inventory control companies. The median values for
the depreciation test and control firms are $31,247,000 and $34,395,000.
The earnings effects of the inventory and depreciation changes are collected
for the test firms from the financial statement footnotes for years following the
change. Companies that use the LIFO inventory method report the current
replacement value of inventory. This value approximates the FIFO inventory
value and is used to calculate the difference between reported LIFO income
and income that would have been reported had the company continued to use
FIFO.
 P. ffea!v. S. Kung and K. Palepu, Accounting procedure changes und CEO c‘ompetwutroll 13

Table 4
Summary statistics for earnings effects of inventory and depreciation method changes as a
percentage of ‘as-if’ earnings for the year of the accounting method changes and the subsequent
ten years.”

Year relative to accounting changeh

0 1 to5 6 to 10

Inuentoq test sample

First quartile - 32.3% ~ 10.7% ~ 6.4%

Median - 19.3 - x.3 ~ 1.1
Median standard deviation’ 5.3 15.7
Third quartile - 11.0 - 4.9 5.8
Percent positive 0.0 3.8 48.9
Depreciation test sample

First quartile 3.6% 5.9% 4.4%

Median 9.6 10.9 7.7
Median standard deviation’ 6.7 4.5
Third quartile 25.7 22.1 23.0
Percent positive 100.0 90.5 100.0
_
“‘As-if’ earnings are FIFO earnings following a change to the LIFO inventory valuation
method, and earnings computed using accelerated depreciation following a change to straight-line
depreciation.
‘The results in years 1 to 5 and 6 to 10 are for the cross-sectional distribution of time-series
averages of the earnings effect of the accounting changes as a percentage of as-if earnings for 52
firms that change to LIFO in the period 1970-1976 and 38 firms that change to straight-line
depreciation in the period 1967-1974.
‘No median standard deviation is reported for year 0 since no time-series standard deviations
can be calculated for a single year.

The effect of the depreciation switch from the accelerated to straight-line

method is calculated from the deferred tax footnote. All the companies in our
depreciation sample continue using the accelerated method for taxes following
the reporting change to the straight-line method. The resulting timing dif-
ference between book and tax incomes gives rise to an adjustment to deferred
taxes which is reported in the tax footnote. We use this value to calculate the
difference between reported income and income that would have been re-
ported had the company continued using the accelerated depreciation
method.4,s

“Our depreciation sample includes six companies that changed to straight-line depreciation
after 1970. For these companies the deferred tax items after 1981 refect Accelerated Cost
Recovery System (ACRS) rates. ACRS decreased the depreciable lives of fixed assets relative to
previous accelerated methods, implying that subsequent to 1981 our adjustments for these
companies are not strictly comparable to accelerated depreciation used for reporting purposes.
However, this change affects at most three years of data. and is unlikely to alter our conclusions.
‘None of the companies in our sample reports the deferred tax effect for depreciation prior to
1971. Our as-if earnings series is therefore incomplete for companies that change to the straight-line
method prior to this date. These years are treated as missing observations in the empirical tests.
 Table 4 reports statistics on the earnings effect of the change to LIFO as a
percentage of earnings under FIFO. During the year of change, the median
earnings reduction from the inventory policy change is 19.3 percent. Time-series
averages of the earnings effect of the inventory change are estimated for each
firm for the first five years (years 1 to 5) and the second five years (years 6 to
10) following the LIFO change. The cross-sectional median of these averages
is - 8.3 percent for the first five years and - 1.1 percent for the second five
years. The percentage effect of the depreciation change on earnings calculated
using accelerated depreciation is also reported in table 4. The median increase
in earnings from the depreciation change is 9.6 percent in the year of the
change. The cross-sectional median of the average earnings effect for the first
live years subsequent to the depreciation change is 10.9 percent, and for the
second five years is 7.7 percent.

3. Statistical tests and results

3. I. The compensation model

The statistical tests described below examine whether, subsequent to an

accounting change, the relation between CEOs’ salary and bonus awards and
reported earnings adjusts to fully offset the earnings effect of the accounting
change. The tests are based on the following firm-specific compensation
model:’

lnt COMP,)= ~a,D,,+Pln(EARN,)+q, 0)

1=l
where

COMP, = salary and cash bonus paid to chief executive offtcer (CEO) during
year t in 1967 constant dollars,
EARN, = accounting earnings before extraordinary items for the firm during
year t in 1967 constant dollars,
D,, = 1 if individual i was CEO of the firm during year t, 0 otherwise,
n zz number of individuals who held the position of CEO of the tirm
during the sample period,
p.a, = firm-specific parameters, to be estimated using time-series data on
compensation and earnings (i = 1,. . , n).

The above compensation model is estimated separately for each firm in the

“This model is hirnilar to a model presented in Murphy (19X5). However. Murphq uses
abnormal stock performance as 3 proxy for management’s performance, and conbtralns the slope
cocfiicicnt (8) to be constantacrossfirms. For our sample, we rqect the hypothesis that the slope
uxHiclent i> equal XKM firms.
 P. Heu!v, S. Kung und K. Palepu, Accounting procedure changes und CEO compensatim 15

sample. There are three features of the model that are worth noting. First, the
model is estimated in a logarithmic form since there is some evidence that
power transformations perform better than linear regressions in estimating
relations between compensation and measures of performance [see Boyes and
Schlagenhauf (1979)]. In addition, prior studies have typically used log
transformations [e.g., Murphy (1985) and Abdel-khalik (1985)]. The use of a
logarithmic form, therefore, makes our results comparable with the findings of
these studies.’
A second feature of the compensation model is that the intercept term (or
the fixed component of compensation), (Y,is allowed to vary across executives.
This enables us to account for differences in manager-specific factors such as
age, ability and education. The elasticity of compensation to earnings, /?, is
assumed to be firm-specific.
The third feature of the model is that the compensation variable is rep-
resented by the salary and bonus payments to the chief executive officer. This
variable excludes several components of compensation, such as performance
awards that are contingent on earnings, and stock option compensation,
because disclosures of these awards are frequently incomplete. Their omission
limits the conclusions of the study since compensation committees could
conceivably adjust these awards, rather than short-term earnings-based awards,
to offset the effect of an accounting method change. However, it is worth
noting that bonus and salary comprise a non-trivial proportion of executives’
total remuneration. For example, in Murphy’s study of 461 executives from
1964 to 1981, salary and bonus account for an average 80 percent of total
remuneration.
The compensation model in eq. (1) posits that management compensation is
in part determined by contemporaneous accounting earnings.x A change in the
rules used to compute accounting earnings will therefore affect executives’
earnings-based compensation unless the compensation committee adjusts for
the effect of the accounting change. The committee can insulate salary and
bonus compensation from the effects of an accounting rule change in three
ways. First, it can continue to use earnings computed under the pre-change
accounting rules. In other words, reported earnings under the new accounting
rules are adjusted for the effect of the change and the compensation-earnings

‘If earnings are negative, we assume their log value is zero. Twenty of the 90 companies in our
sample (29 company-years) are adjusted in this way. The effect of this assumption is to limit
managers to receive earnings-dependent compensation only when their company earns profits.
consistent with the option characteristics of most bonus contracts [see Healy (1985)]. We also
estimate mode1 (1) in linear form, allowing earnings to be negative. and constraining negative
earnings to zero. Our conclusions are not sensitive to this adjustment to earnings, or to the
logarithmic transformation.
‘We also test whether lagged earnings are related to salary and bonus awards since salary
adjustments could be based on prior years’ earnings. We find no evidence that lagged earnings are
related to bonus and salary awards.
16 J? Ifrrr~~:S. Kung and K. Pulepu, Accountingprocedure changes und CEO compensation

relation in eq. (1) is applied to the adjusted earnings numbers. Second, the
committee can use reported earnings without any adjustment for the account-
ing change but can modify the parameters (Y and /3 in eq. (1) such that, on
average, the compensation awarded is unaffected by the accounting change.
The tests described below examine whether compensation is insulated from
the effects of accounting changes in either of these two ways. The third way for
the compensation committee to offset the effect of an accounting change on
CEOs’ remuneration is through adjustments to stock-based compensation. As
noted above, we do not collect data on stock-based awards to CEOs for our
sample and therefore do not test this hypothesis.

3.2. Tests of earnings adjustment

To examine whether reported earnings are adjusted for the effect of an

accounting change in determining management compensation, we define two
earnings variables: reported earnings and ‘adjusted’ earnings. Reported earn-
ings (REARN,) are based on one set of accounting rules before the accounting
policy change, and another set after the change. Adjusted earnings (AEARN,)
are computed using the same set of rules both before and after the change. In
other words, AEARN, equal REARN, for periods prior to the accounting
change; REARN, are adjusted for the effect of the accounting change to
generate AEARN, for periods after the change.
To test whether AEARN, or REARN, are used to determine top manage-
ment compensation subsequent to an accounting change, we estimate the
following modified version of eq. (1):

ln( COMP,) = 2 a,D,, + /3 ln( AEARN,) + X In

I=1

Eq. (2) modifies (1) by including an additional variable ln(REARN,/

AEARN,). Since REARN, and AEARN, are equal before the accounting
change, this variable has a value of zero during the pre-change period. In the
post-change period, the variable represents the percentage earnings effect of
the accounting change on original earnings. If management compensation
after the accounting change is computed using earnings under the original
rules, and not reported earnings, we expect /I to be positive and X to be zero.
If compensation is computed using reported earnings after the accounting
change, both p and X are expected to be positive.
To test the significance of the coefficients for /? and h, eq. (2) is estimated
separately for each firm in the sample. The sample distribution of the
estimated r-statistics for /? and A are used to test the significance of these
 P. Heu!~‘, S. Kung und K. Pulepu, Accountrng procedure chunges und CEO compemuiion 17

parameters. For each parameter, the following sample Z-statistic is computed:

where
t, = t-statistic for firm j associated with the estimate of the parameter (/3 or
A)*
k, = degrees of freedom in regression for firm j,
N = number of firms in the sample.
The t-statistic for firm j is distributed Student-r with a variance of k,/( k, - 2).
Under the Central Limit Theorem, the sum of the standardized t-statistics is
normally distributed with a variance of N. The Z-statistic for each of the
parameters is therefore a standard normal variate under the null hypothesis
that the parameter (/3 or h) is not significantly different from zero.
A second and equivalent test compares the explanatory power of eq. (2)
with the following restricted form of that equation:

ln( COMP,) = t a,D,( + j3 ln( AEARN,) + E,. (3)

I==1

Eq. (3) restricts X in eq. (2) to be equal to zero. An F-statistic is used to test
whether this restriction results in a significant reduction in the explanatory
power of eq. (2):

SSR, - SSR,
F,=
SSRJk, ’

where SSR, and SSR 2 are the sums of squares of residuals of eqs. (3) and (2).
respectively, and k, is the degrees of freedom in regression eq. (2) for firm ,j.
An F-statistic is computed for each firm in the sample. The significance of
the sample distribution of F-statistics is tested by the following statistic:
.Y

x2= C -2lnp,,
/=1

where p, is the probability associated with the F-statistic of firm j and N is

the number of firms in the sample. Under the null hypothesis that the sample
distribution of the F-statistics is no different from that expected by chance, the
above statistic is &i-squared distributed with 2N degrees of freedom.’

‘For a detailed discussion of both these tests. see Christie (19X6). Roth the tests discussed here
are based on the sample distribution of the parameter estimates. In using these tests. it is assumed
that the parameters are independent across the firms in the sample. Further discussion of this
assumption is deferred to later in the paper.
18 P. H&y, S. Kung and K. Pulepu, Accountrng
procedure changes and CEO cmpmsation

Table 5
Summary of estimated coefficients for regression tests of the hypothesis that reported earnings are
adjusted to FIFO earnings for compensation purposes following a change to the LIFO inventory
method.a

ln(COMP,,)=~a,D,,+Pln(A~ARN,)+Xln + e,.h
,=I

Mean 0.3170 0.3613

Z-statistic’ 18.12d 5.83d
First quartile 0.0664 - 0.0443
Median 0.2397 0.2701
Third quartile 0.5290 0.8111
Percent positive 92.31gd 71.15Sd
x2-statistic (df = 106) 184.54e

“These results are for the cross-sectional distribution of time-series regressions for 52 firms that
changed to LIFO in the period 1970-1976. Each time-series contains between 14 and 21
observations.
bCOMP, = salary + bonus for CEO in year I: AEARN, = as-if earnings in year t computed
using the FIFO inventory method; REARN, = reported earnings in year t, computed using FIFO
before and LIFO after the accounting change; D,, = 1 if individual 1 is CEO of the firm in year t
and 0 otherwise; and n = number of individuals who held the CEO position in the sample period.
‘Under the null hypothesis each Z-statistic is distributed unit normal.
dSignificant at the one percent level using a two-tailed test.
‘Significant at the one percent level using a one-tailed test.

3.3. Earnings adjustment test results

3.3. I. Inventory sample

Table 5 presents regression results for the test sample of 52 firms that
changed from FIFO to LIFO. lo.11 The estimated coefficient p on the adjusted
earnings variable (AEARN) is positive for 92 percent (48 of 52) of the sample
firms. A binomial test indicates that there is a higher proportion of positive
coefficients than expected by chance at the one percent significance level.12

“‘The control sample firms are not analyzed in this section because we do not have information
on adjusted earnings for these firms.
“Twenty-three of the 52 company regression residuals exhibit serial correlation. We use a
Cochran-Orcutt transformation for these companies [see Theil (1971) for a description of this
technique]. The results do not change significantly. The results reported in table 5 arc therefore for
the unadjusted estimates.
‘*See Siegel (1956) for a description of the binomial test. The test assumes that the coefficients
are cross-sectionally independent. As noted above, further discussion of this assumption is
deferred until later in the paper.
The Z-statistic, which tests the joint significance of the AEARN coefficients for
the 52 sample companies, is significant at the one percent level, enabling us to
reject the hypothesis that there is no significant relation between accounting
earnings and top management bonus and salary compensation.
The estimated coefficient h for the variable representing the effect of the
change to LIFO (REARN/AEARN) on executives’ compensation, is positive
for 71 percent (37 of 52 firms) of the sample. A binomial test rejects the
hypothesis that the proportion of positive coefficients is equal to that expected
by chance at the one percent level. The sample Z-statistic, testing the collec-
tive significance of the X coefficients for the 52 firms in the sample. is
significant at the one percent level. i3 This evidence is inconsistent with the
hypothesis that CEOs’ salary and bonus compensation is based on earnings
adjusted for the effect of the inventory method change (FIFO earnings).
Finally, the X’-statistic shown in table 5 aggregates the probabilities associ-
ated with the F-statistics for all firms in the sample. The F-statistic compares
the explanatory power of a regression in which X is restricted to be zero with
one in which it is not. The x’-statistic for the 52 firms in the sample is 184.5
and is significant at the one percent level. This evidence, consistent with that
indicated by the Z-statistic discussed above, suggests that salary and bonus
compensation is related to reported earnings, unadjusted for the effect of the
change to LIFO. There is no evidence that, for compensation purposes,
reported earnings are adjusted to offset the effect of the change in accounting
policy for valuing inventory.

3.3.2. Depreciution sample

The results for the 38 test firms that changed from accelerated to straight-line
depreciation are similar to the results for the inventory sample. Table 6 reports
a summary of the ordinary least squares estimates of model (2). The estimates
of the earnings coefficient /3 are positive for 84.2 percent (32 of 38) of the
sample firms. A binomial test indicates that this number of positive estimates
is significantly greater than that expected by chance at the one percent level
using a two-tailed test. The Z-statistic, which tests the sample significance of
the estimates of /?, is also significant at the one percent level.
The estimates of X, the coefficient on the earnings variable that captures the
effect of the accounting change, are positive for 60.5 percent (23 of 38) of the
companies. The Z-statistic, which tests the significance of the sample estimates
of h, is significant at the one percent leveli Consistent with this, the

“Seventy-seven percent of the estimates of fi and 37 percent of the estimatca of X arc

individually significant at the ten percent level. However, assuming independence across firma in
the sample. a more powerful test is to examine the collective signilicance of the estimated
coefficients using the Z-statistic discussed above.
14Fifty percent of the estimates of j3 and 37 percent of the estimates of X are individually
significant at the ten percent level.
20 P. Heu/v. S. Kung und K. Pulepu, Accouniingprocedure changes und CEO compensrrmn

Table 6
Summary of estimated coefficients for regression tests of the hypothesis that reported earnings are
adjusted to accelerated depreciation earnings for compensation purposes following a change to the
straight-line depreciation method.”

In(L.OMP,)=~a,D,,+Pln(AEARh;)~hln + F,.h
,=I

Mean 0.1745 0.2752

Z-statisti? 15.78d 2.16d
First quartile 0.0154 - 0.6645
Median 0.1642 0.3234
Third quartile 0.2640 0.7393
Percent positive 84.21%d 60.53%
X*-statistic (df = 76) 164.77’

“These results are for the cross-sectional distribution of time-series regressions for 38 firms that
changed to straight-line depreciation in the period 1970-1976. Each time-series contains between
14 and 21 observations.
‘COMP, = salary + bonus for CEO in year t; AEARN, = as-if earnings in year t, computed
using the accelerated depreciation method; REARN, = reported earnings in year 1, computed
using accelerated depreciation before and straight-line depreciation after the accounting change;
D,, = 1 if individual i is CEO of the firm in year t and 0 otherwise; and n = number of individuals
who held the CEO position in the sample period.
‘Under the null hypothesis each Z-statistic is distributed unit normal.
dSignificant at the one percent level using a two-tailed test.
‘Significant at the one percent level using a one-tailed test.

xz-statistic, which tests whether the accounting change effect variable provides
an increase in explanatory power of the sample regressions, is significant at the
one percent level. This evidence is inconsistent with the hypothesis that
compensation committees continue to use earnings based on accelerated
depreciation in determining top management compensation after a change to
straight-line depreciation for reporting purposes.
In summary, our results for both inventory and depreciation samples
indicate that there is a significant relation between top executive salary and
bonus compensation and reported accounting earnings. The results indicate
that when the two accounting policies are changed, compensation committees
do not adjust reported earnings for the effects of the accounting changes.
One potential limitation to our findings is that the statistical tests used to
aggregate regression results across companies assume the sample observations
to be independent. Since the inventory and depreciation changes are clustered
in time and concentrated in several industries, this assumption may be
violated. To investigate cross-sectional dependence, we estimate the cross-sec-
tional correlations of the residuals from model (2) for 42 companies in the
 P. Heu!v, S. Kang and K. Palepu, Accounling procedure changes and CEO compensation 21

inventory sample with complete data available from 1966 to 1980, and 24
companies in the depreciation sample with data available from 1962 to 1976.
There are 861 pairwise residual correlation coefficients for the 42 inventory
companies and 276 coefficients for the 24 depreciation companies. The mean
correlation coefficient is only 0.0102 for the inventory sample and 0.0193 for
the depreciation sample, neither significantly different from zero. We thus find
no strong evidence of cross-sectional dependence.

3.4. Tests of compensation model adjustment

The above tests examine whether compensation committees adjust reported

earnings for the effects of accounting changes in determining bonus and salary
compensation. Committees also have the option of adjusting the fixed compo-
nent of compensation or the elasticity of compensation to earnings to offset
the effect of an accounting change. For example, committees can increase
executives’ fixed compensation [represented by (Yin model (l)] or increase the
elasticity of compensation to earnings (represented by /?) following a change
from FIFO to LIFO inventory policy. Executives’ remuneration would then be
a function of reported earnings, but the compensation effect of using lower
LIFO earnings would be approximately offset by higher fixed rewards, or a
higher bonus payment for a given percentage increase in earnings,
We test whether there is a change in the parameters of the
compensation-earnings relation subsequent to an accounting method change
and whether changes on average offset the effect of accounting changes on
earnings-based remuneration. Finally, we estimate the potential effect of the
accounting changes on bonus and salary awards if no adjustment is made to
either reported earnings or parameters of the compensation-earnings relation.

3.4.1. Tests of parameter changes

To test whether the parameters of the compensation models change after an

accounting change, we estimate the following regression model for the test
samples:

ln( COMP,) = k (Y,D,~ + PI ln( REARN,) + &DUM,

1=1

+&DlJM, ln( REARN,) + u,, (4)

where DUM, is 0 in years prior to the accounting method change and 1 after
the change, & and & are the adjustments to the intercept and slope
parameters of the compensation model following the accounting change, and
D,,, REARN,, (Y, and /3i are as defined in eq. (2).
22 P. Heu!v, S. Kung and K. Puiepu, Accounttng procedure changes und CEO compensation

Under the null hypothesis that the fixed component of compensation and
the elasticity of compensation to earnings are unaltered following an account-
ing change, both & and & are expected to be zero. We also estimate eq. (4)
for control firms using the same dummy variables (DUM,) as were used for
the matched test firms. If there are no economy- or industry-specific changes
in the parameters of the compensation model, & and & for the control firms
are expected to be zero.
We use a chi-square test to examine the hypothesis that & and & are
jointly zero. To compute the &i-square statistic, we estimate the following
restricted form of eq. (4) for each firm in the sample:

ln(COMP,) = i LY,D,~+ PI ln( REARN,) + w,. (5)

r=l

Using the residuals of eqs. (4) and (5) the following statistic is computed for
each firm:

F = (SSR,- SSR,)/2
J SSR,/k, ’

where SSR, and SSR, are the sums of squares of residuals for firm j from
eqs. (5) and (4), respectively, and k, is the number of degrees of freedom in
regression (4) for firm j. The sample distribution of the above F-statistics is
used to test their significance by computing the chi-square statistic discussed
in section 3.2.

3.4.2. Tests of relation between parameter changes and accounting changes

We evaluate whether structural changes in the test firms’ compensation-

earnings relation on average offset the effect of the accounting change on
earnings-based remuneration. If compensation committees modify the relation
in this way, salary and bonus awards subsequent to the accounting change will
approximate awards that would have been paid if there had been no account-
ing change and no model change.
The log of expected compensation in the absence of accounting and model
changes is

ln{E(COMP,)} = fl: &‘,D,, + 8, In(AEARN,), (6)

{=I

where 2, and p^, are estimates from eq. (4) for the log of fixed compensation
and the elasticity of compensation to earnings prior to the accounting change,
and COMP,, D,, and AEARN, are defined in eq. (1). Expected compensation
 P. Heu!v. S. Kung und K. Palepu, Accounting procedure chunges and CEO compensation 23

is therefore the antilog of the right-hand side of eq. (6). Expected compensa-
tion under eq. (6) is estimated for each test firm for years subsequent to the
accounting change and percentage prediction errors are computed as follows:

PE = COMP, - E( COMP,)
f x 100. (7)
COMP,

Each prediction error is an estimate of the percentage difference between

actual compensation, awarded on the basis of reported earnings and the
revised compensation model, and the forecast of compensation in the absence
of the accounting change and the model change. Average percentage predic-
tion errors are estimated for each firm as follows:

where r1 is the first year following the accounting method change and r2 is at
least or + 5. and at most 71 + 10, depending upon data availability.
Under the null hypothesis that the compensation committee adjusts the
compensation-earnings relation to offset on average the salary and bonus
effect of the accounting change, the time-series average percentage prediction
error for each firm is zero. If the compensation committee uses reported
earnings to award earnings-based compensation and does not adjust the model
to offset the effect of the accounting change, the average percentage prediction
error is expected to be negative for inventory test firms and positive for
depreciation test firms. A Student-t test is used to evaluate the significance of
the cross-sectional mean of the average percentage prediction errors.
We also calculate prediction errors for the inventory and depreciation
control firms to examine changes in salary and bonus awards induced by
industry- and economy-wide factors. The control firms do not make changes in
inventory and depreciation methods and therefore do not have adjusted
earnings series. We substitute reported earnings for adjusted earnings in eq. (6)
and estimate predicted compensation and percentage prediction errors for
each control firm during the same calendar years used to predict compensation
for its matched test firm. If there are economy- or industry-specific changes in
compensation that coincide with but are unrelated to the accounting changes,
the time-series average prediction error for the control firms is non-zero.
We compare the average percentage prediction error for each matched pair
of test and control firms and use a Student-t test to evaluate the significance of
differences between the samples. If the compensation committee adjusts the
model parameters to offset the effect of an accounting change on earnings-based
compensation, we expect no difference in average prediction errors between
24 P. Hea(v. S. Kung rend K. Pulepu. Accounting procedure change.7 crnd CEO compensation

these pairs of firms. Alternatively, if there is no adjustment for the accounting

change, we expect the average percentage prediction errors for inventory
(depreciation) test firms to be lower (higher) than errors for the control firms.

3.4.3. Potential efSect of accounting changes on compensation

Finally, we examine the effect of accounting changes on salary and bonus

awards if compensation committees do not adjust reported earnings or the
parameters of the compensation-earnings relation. CEOs then receive lower
earnings-related compensation subsequent to a change to the LIFO inventory
method, and higher compensation following a change to straight-line deprecia-
tion.
We estimate the percentage effect of the accounting changes on earnings-
related compensation (EFF,), assuming no adjustment to the earnings defini-
tion or the compensation-earnings relation, as follows:

EFF = - E(COMP,,)
E(COMP,,)
t COMP,
x 100,

where COMP, is the actual salary and bonus awarded in year t, and E( COMP,,)
and E(COMP,,) are expected compensation in year t based on reported
earnings and adjusted earnings, respectively. E(COMP1,) and E(COMP,,) are
computed as the antilogs of the right-hand side of the following two equa-
tions:

ln( COMP,,) = i 2, Dlt + ,& ln( REARN,), (9)

r=l

In( COMP,,) = i &,D,, + ,l.&ln( AEARN,), (10)

r=l

where REARN, is reported earnings, AEARN, is adjusted earnings, &, and p^,
are estimates from eq. (4), and D,, is a dummy defined in eq. (4). The
percentage effects of the inventory and depreciation accounting changes on
salary and bonus awards are estimated for each test firm for years subsequent
to the method changes.

3.5. Compensation model adjustment results

3.5. I. Inventory sample

Table 7 presents a summary of the estimates of eq. (4) coefficients for the 50
matched pairs of firms in the inventory test and control samples. Parameters
 P. HeaJv, S. Kang und K. Palepu, Accounting procedure changes and CEO compensution 25

Table I
Summary of estimated coefficients for regression tests of the hypothesis that the parameters of the
compensation-earnings relation change following a change to the LIFO inventory method.”

ln(COMP,) = i&,0,, + Rtln(REARN,) +&Or/M, + &DUM,ln( REARN,) + u,.~

,=l

Test sumplec

Mean 0.3937 1.2497 - 0.0944

First quartile 0.1238 - 2.1906 ~ 0.5467
Median 0.2966 0.9304 - 0.0625
Third quartile 0.6465 6.1561 0.2046
Percent positive 92.00CJoe 58.00% 46.00%
X2-statistic (df = 100) 193.67’
Conrrol sumple’
Mean 0.2282 ~ 0.2296 0.0317
First quartile 0.0048 - 2.8636 -0.1963
Median 0.1204 0.0594 0.0425
Third quartile 0.3815 1.9932 0.2317
Percent positive 77.00%c 50.004c 56.00%
X2-statistic (df = 100) 208.64’
Difference between test und control sumpies”

Mean 0.1655 1.4793 -0.1261

Z-statistic 3.35’ 1.84 ~ 1.69
First quartile - 0.0940 - 2.5559 - 0.6514
Median 0.1326 1.5751 - 0.1759
Third quartile 0.5661 7.5306 0.2967
Percent positive 60.00% 60.00% 52.00%

“These results are for the cross-sectional distribution of time-series regressions for 50 test firms
and 50 control firms. Each time-series contains betwen 14 and 21 observations.
hCOMP, = salary + bonus for CEO in year 1; REARN, = reported earnings in year t; D,, = 1 if
individual i is CEO of the firm in year I and 0 otherwise; n = number of individuals who held the
CEO position in the sample period; and DUM, = 0 prior to the year of the inventory change and
1 thereafter.
‘The test sample comprises 50 firms that change to LIFO in the period 1970-1976. Each test
firm has a matched control firm with the same 2-digit SIC code and with no inventory or
depreciation method changes ten years before and after the year of the test firm’s method change.
Control firms are found for 50 of 52 inventory test firms.
dThese distributional statistics are for the differences in coefficients between matched pairs of
test and control firms. The Z-statistic tests the significance of the sample mean difference for each
coefficient.
‘Significant at the one percent level using a two-tailed test.
‘Significant at the one percent level using a one-tailed test.
26 P. Heu!v, S. Kung und K. Pulepy Accountrng procedure changes und CEO compensation

& and & in the regression are used to examine whether the fixed component
of compensation and the elasticity of compensation to earnings change subse-
quent to a change from FIFO to LIFO. The estimated values of & are positive
for 58 percent of the test firms and the mean value is 1.2497. The percent of
positive coefficients for the control firms is 50 percent and the mean of the
coefficients is -0.2296. Forty-six percent of the estimated values of & are
positive for the test firms and the mean estimate is - 0.0944. The correspond-
ing values for the control sample are 56 percent and 0.0317. The x*-statistics,
which test the hypothesis that & and & are jointly zero, are significant at the
one percent level for both the test and control firms. Thus, there is some
evidence of a structural change in the compensation-earnings relation for the
inventory sample.
An examination of the coefficient estimates in table 7 indicates that there
are systematic differences in the values for test and control samples. We
estimate the differences in coefficients for matched pairs of test and control
firms. The sample distributions of these differences are reported in table 7. A
Z-test, described earlier in section 3.2, is used to test the significance of the
mean coefficient differences. The test firms have a significantly higher com-
pensation-earnings elasticity than the control firms. Subsequent to the
accounting change, the test firms experience an increase in fixed compensation
and a decrease in their compensation-earnings elasticity relative to the control
firms. However, these differences are statistically insignificant. These findings
indicate that (1) firms that change to LIFO have higher compensation-earn-
ings elasticities than firms that do not change their inventory method, and (2)
the changes in model parameters are not systematically related to the account-
ing method change.
Results of tests of whether the structural change in the compensation model
offsets the effect of the accounting change on earnings-related remuneration
are reported in table 8. The cross-sectional mean (median) of the average
percent prediction error for compensation is 9.5 (10.5) percent for the test
sample. The t-statistic, that evaluates the significance of the mean, is signih-
cantly different from zero at the five percent level. The mean (median) for the
control sample is 8.3 (11) percent. The t-statistic on the mean is also signifi-
cantly different from zero. These results indicate that on average there is an
economy- or industry-related increase in compensation of eight to eleven
percent that coincides with the period following the LIFO changes, the late
1970s and early 1980s. The test firm CEOs have marginally larger average
percentage increases in salary and bonus compensation during these same
years. However, the t-statistic evaluating the difference in these means is not
significant. The results therefore support the null hypothesis that the com-
pensation committee adjusts the model parameters to offset the effect of the
accounting change.
 P. Heu!v, S. Kong und K. Palepu. Accounting procedure changes and CEO compensution 21

Table 8
Summary of average percentage prediction errors for compensation in years subsequent to a
change to the LIFO inventory method.a

Test Control Difference between test

sample’ sampleb and control samples

Mean 9.46% 8.31% 1.15%

r-statistic 3.17c 2.05’ 0.49
Mean standard deviation 14.91% 14.07% 0.84%
First quartile ~ 6.95% - 3.55% - 20.00%
Median 10.48% 11.15% ~ 0.24%
Third quartile 20.91% 24.70%’ 16.29%
Median standard deviation 10.11% 8.23% - 1.01%
Percent positive 68.00% 68.00% 48.008

“Percentage prediction errors are the percentage difference between actual compensation and
compensation that would have been paid in the absence of a LIFO change and a model change
[see eq. (7)]. The results are for the cross-sectional distribution of time-series estimates of mean
percentage prediction errors for 50 test firms and 50 control firms. Each time-series contains
between six and eleven observations.
‘The test sample comprises 50 firms that changed to LIFO in the period 1970-1976. Each test
firm has a matched control firm with the same 2-digit SIC code and with no inventory or
depreciation method changes ten years before and after the year of the test firm’s method change.
Control tirms are found for 50 of 52 inventory test firms.
‘Significant at the five percent level using a two-tailed test.

An alternative, and we believe equally plausible, explanation for the above

finding is that the effect of the accounting change on compensation is not large
enough, relative to the effect of the time-dependent change in compensation,
to enable us to discriminate between the null and alternative hypotheses. This
explanation is consistent with the data. Table 9 reports the distribution of the
percentage effect of the LIFO change on salary and bonus awards assuming
the compensation committee does not adjust the earnings definition or the
parameters of the compensationearnings relation. The mean and median
percent decreases in salary and bonus awards in the year of the LIFO change
are 13.9 and 6.7 percent, respectively.15 A time-series average of the compensa-
tion effect of the change is estimated for each firm for an eleven-year period
(years 0 to 10) and for the ten years subsequent to the change (years 1 to 10).
The cross-sectional mean (median) of these averages is - 3.9 ( - 2.3) percent
for the full eleven years, and - 2.7 (- 1.5) percent for years 1 to 10.

IsThis is a sizeable decrease in salan, and bonus that far exceeds the effect of the inventory
change in subsequent years’ compensation. We therefore test whether the compensation commit-
tee adjusts reported earnings for the effect of the accounting change in only the year of the change
rather than in all following years. We estimate eq. (2) with the explanatory variable
ln[ REA RN,/AEA RN,] being set to zero in all years other than the year of the change to LIFO.
The coefficient is positive and significant, implying that the compensation committee does not
adjust compensation for the effect of the inventory method change even in the year of the change.
28 P. Heu!v, S. Kmg und K. Palepu, Accountingprocedure chunges and CEO compensation

Table 9
Summary statistics for compensation effects of inventory method change as a percentage of actual
compensation for the year of the inventory change and the subsequent ten years.”

Year relative to accounting change’

0 1 to10 0 to 10

Mean - 13.87% - 2.67% - 3.93%

Mean standard deviation’ 5.34 1.32
First quartile - 17.54 - 4.52 -6.19
Median - 6.72 ~ 1.48 - 2.34
Median standard deviation 2.79 3.68
Third quartile - 2.5 - 0.02 -0.55

“The compensation effect of an inventory method change as a percentage of actual compensa-

tion in year r is [E(COMP,,) - E(COMP,,)/COMP,] x 100. E(COMP,,) and E(COMP,,) are
expected compensation using reported and adjusted earnings respectively and are computed from
eqs. (9) and (10). COMP, is the actual compensation paid in year t.
‘The results in years 1 to 10 and 0 to 10 are for the cross-sectional distribution of time-series
averages of the compensation effect of the inventory change as a percentage of actual compensa-
tion for 52 firms that change to LIFO in the period 1970-1976.
‘No mean or median standard deviations are reported for year 0 since no time-series standard
deviations can be calculated for a single year.

3.5.2. Depreciation sample

A summary of the estimates of eq. (4) coefficients for the 37 pairs of

matched firms in the depreciation test and control samples are reported in
table 10. The estimated values of & are positive for 66.7 percent of the test
sample and 38.9 percent of the control sample. The mean estimates of & for
these samples are 1.8454 and -3.1238, respectively. The percent of positive
estimates for & is 36.1 for the test sample and 63.9 for the control sample.
The mean estimate of /I, is -0.1564 for the test firms and 0.3088 for the
control firms. The x*-statistics that test the joint significance of & and & are
significant at the one percent level for both samples, suggesting that there has
been a structural change in the relation between compensation and earnings
for both the test and control firms.
We also examine whether the coefficient estimates for the test and control
samples are significantly different. Table 10 reports the sample distributions of
differences in coefficients for matched pairs of test and control firms. On
average the depreciation test firms have higher compensation-earnings elastic-
ities than the control firms. The Z-statistic, testing the significance of the mean
difference, is significant at the one percent level using a two-tailed test. In
addition, relative to the control firms, the test firms experience significant
increases in fixed compensation and decreases in their compensation-earnings
elasticities subsequent to the accounting change. This indicates that (1) firms
 P. Hea!y, S. Kung and K. Palepu. Accounting procedure changes and CEO compensation 29

Table 10
Summary of estimated coefficients for regression tests of the hypothesis that the parameters of the
compensation-earnings relation change following a change to the straight-line depreciation
method.a

ln(COMP,)=~a,D,,+P,ln(REARN,)+~2DI/M,+P,DUM,ln(REARN,)+u,.h
,=I

Test sumple’

Mean 0.2650 1.8454 - 0.1564

First quartile - 0.0008 - 2.1288 - 0.2866
Median 0.1877 0.5655 - 0.0490
Third quartile 0.4658 3.1121 0.2181
Percent positive 75.00%%’ 66.67% 36.11%
X2-statistic (df = 74) 166.75g

Control sample’

Mean 0.1612 - 3.1238 0.3088

First quartile 0.0031 - 4.2258 -0.1335
Median 0.1331 - 1.1977 0.1399
Third quartile 0.2813 1.2169 0.4863
Percent positive 77.78%%’ 38.89% 63.89%

X2-statistic (df = 74) 161.5gg

Difference between test und control samplesd

Mean 0.1038 4.9692 - 0.4652

Z-statistic 3.55’ 5.20’ - 4.8Xe
First quartile - 0.1360 ~ 3.0872 - 0.8080
Median 0.0994 2.6294 - 0.2809
Third quartile 0.2901 9.3007 0.2827
Percent positive 61.11% 61.11% 38.89%

“These results are for the cross-sectional distribution of time-series regressions for 37 test lirms
and 37 control firms. Each time series contains between 14 and 21 observations.
bCOMP, = salary + bonus for CEO in year 1; REARN, = reported earnings in year t: D,, = 1 if
individual i is CEO of the firm in year t and 0 otherwise; n = number of individuals who hold the
CEO position in the sample period; and DUM, = 0 prior to the year of the depreciation change
and 1 thereafter.
‘The test sample comprises 37 firms that changed to straight-line depreciation in the period
1967-1974. Each test firm has a matched control firm with the same 2-digit SIC code and with no
inventory or depreciation method changes ten years before and after the year of the firm’s method
change. Control firms are found for 37 of 38 depreciation test firms,
dThese distributional statistics are for the differences in coefficients between matched pairs of
test and control firms. The Z-statistic tests the significance of the sample mean difference for each
cofficient.
‘Significant at the five percent level using a two-tailed test.
‘Significant at the one percent level using a two-tailed test.
sSignificant at the one percent level using a one-tailed test.

JHC R
30 P. Hea@, S. Kang and K. Palepu, Accounfingprocedure chmges and CEO compensut~on

Table 11
Summary of average percentage prediction errors for compensation in years subsequent to a
change to the straight-line depreciation method.”

Difference between
Test Control test and control
sample’ sample’ samples

Mean 6.94% 7.93% - 0.99%

I-statistic 2.78’ 2.40’ -0.17
Mean standard deviation 13.41% 15.04% 1.63%
First quartile - 9.49% ~ 1.19% -23.43%
Median 4.71% 9.51% -4.31%
Third quartile 22.75% 15.78% 18.17%
Median standard deviation 9.35% 10.80% 3.11%
Percent positive 56.76% 75.67% 45.94%

“Percentage prediction errors are the percentage difference between actual compensation and
compensation that would have been paid in the absence of a straight-line depreciation change and
a model change [see eq. (7)]. The results are for the cross-sectional distribution of time-series
estimates of mean percentage prediction errors for 37 test firms and 37 control firms. Each
time-series contains between six and eleven observations.
bThe test sample comprises 37 firms that changed to straight-line depreciation in the period
1967-1974. Each test firm has a matched control firm with the same 2-digit SIC code and with no
inventory or depreciation method changes ten years before and after the year of the test firm’s
method change. Control firms are found for 37 of 38 depreciation test firms.
‘Significant at the five percent level using a two-tailed test.

that change depreciation accounting policies have higher compensation-earn-

ings elasticities than firms that do not change their depreciation method, and
(2) the accounting change firms have a decreased emphasis on earnings-based
compensation subsequent to the accounting change.
To evaluate whether the structural change in the compensation-earnings
relation offsets the effect of the accounting change on salary and bonus
awards, we examine the distribution of average percentage prediction errors in
compensation subsequent to the depreciation change for both the test and
control firms. These results are presented in table 11 and are similar to the
inventory findings. There is a 7.9 (9.5) percent mean (median) increase in
bonus and salary compensation for the control firms. The t-statistic that
evaluates the significance of the mean increase is significant at the five percent
level, implying that there is an economy- or industry-related increase in
compensation in the period following the depreciation method changes, the
1970s. The test firm CEOs had a 6.9 (4.8) percent average (median) increase in
salary and bonus compensation during these years which is also significant.
However, the t-statistic evaluating the difference in the mean estimates for the
control and test samples is not significant. We therefore cannot reject the null
hypothesis that the compensation committee adjusts the compensation model
parameters to offset the effect of the accounting change.
 P. He&, S. Kung und K. Palepu. Accounting procedure chunges und CEO compensutron 31

Table 12
Summary statistics for compensation effects of depreciation method change as a percentage of
actual compensation for the year of the depreciation change and the subsequent ten years.”

Year relative to accounting changeh

0 1 to 10 0 to 10
Mean 2.36% 2.73% 2.69%
Mean standard deviation’ - 2.51 2.49
First quartile 0.00 0.05 0.05
Median 0.78 1.45 1.43
Median standard deviation’ 1.19 1.21
Third quartile 4.65 5.50 5.29

“The compensation effect of a depreciation method change as a percentage of actual compensa-

tion in year f is [E(COMP,,) - EL(COMP,,)/COMP,] x 100, where E(COMP,,) and E(COMP,,)
are expected compensation using reported and adjusted earnings respectively and COMP, is the
actual compensation paid in year 1. COMP,, and COMP,, are computed by using eqs. (9) and
(10).
bThe results in years 1 to 10 and 0 to 10 are for the cross-sectional distribution of time-series
averages of the compensation effect of the depreciation change as a percentage of actual
compensation for 38 firms that change to straight-line depreciation in the period 1967-1974.
‘No mean or median standard deviations are reported for year 0 since no time-series standard
deviations can be calculated for a single year.

Once again, we believe that an equally plausible explanation for the above
finding is that the magnitude of the effect of the accounting change on
compensation is small relative to the effect of the time-dependent change in
compensation, preventing us from discriminating between the null and alter-
native hypotheses. Table 12 reports the distribution of the percentage effect of
the depreciation change on bonus and salary awards assuming that the
compensation committee does not adjust the earnings definition or the param-
eters of the compensation-earnings relation. The mean (median) percentage
increase in salary and bonus awards in the year of the depreciation change is
2.4 (0.8) percent. A time-series average of the compensation effect of the
change is estimated for each firm for years 0 to 10 and years 1 to 10. The
cross-sectional mean (median) of these averages is 2.7 (1.4) percent for years 0
to 10 as well as for years 1 to 10.

4. Discussion of results and conclusion

This paper investigates the effect of accounting policy changes on CEOs’

salary and bonus compensation. A number of accounting studies postulate
that it is costly for compensation committees to adjust CEO9 bonus and
salary awards for changes in accounting procedures. If committees and
managers have rational expectations, this ‘compensation hypothesis’ implies
32 P. He+, S. Kong and K. Pulepu, Accounting procedure changes md CEO compensutrm

that committees write remuneration contracts anticipating managements’ in-

centives to opportunistically select accounting rules to increase their com-
pensation. No adjustment to managements’ compensation schedules will then
be observed following a change in accounting rules. In this study, we docu-
ment the potential impact of accounting changes on CEOs’ compensation and
perform two tests of the compensation hypothesis. The first test examines
whether, subsequent to an accounting change, compensation is based on
earnings adjusted for the effect of the change. The second examines whether
the compensation model parameters are adjusted to nullify the earnings effect
of the accounting change.
Two accounting changes are selected: changes from FIFO to LIFO inven-
tory method and changes from accelerated to straight-line depreciation. These
are selected to increase the power of our tests. They both have a large effect on
reported earnings. In addition, a change to LIFO typically decreases earnings,
whereas a change to straight-line depreciation usually increases earnings.
Our results show that the potential effect of inventory and depreciation
accounting changes on CEOs’ bonus and salary remuneration is generally
small compared to economy-wide changes in compensation over time. The
median potential decrease in compensation following a switch from FIFO to
LIFO is 6.7% in the year of the switch and 1.5% per year during the next ten
years. In contrast, there is an 11.2% median increase in CEOs’ compensation
per year due to economy- and industry-wide factors that are contemporaneous
with, but unrelated to, the accounting changes. The median potential increase
in CEOs’ compensation following a depreciation accounting change is 0.8% in
the first year and 1.5% per year during the next ten years. Once again, there is
a 9.5% median increase in CEOs’ annual compensation due to industry-wide
factors that are contemporaneous with, but unrelated to, the accounting
changes.
Our tests of the earnings definition used as a basis for compensation
indicate that CEOs’ bonus and salary awards are based on reported earnings
both before and after the accounting changes. We find no evidence that,
subsequent to either the inventory change or the depreciation change, reported
earnings are transformed to earnings under the original accounting method for
computing compensation awards. The costs of such a transformation do not
appear to be significant for the accounting changes considered in this paper:
we are able to undo the effects of the changes using publicly available
information, even in years subsequent to the method changes. Of course, there
may be other costs of adjusting compensation for the effect of the accounting
change. For example, it may be costly for the compensation committee to
distinguish accounting changes selected by managers to increase their re-
muneration from those selected to maximize the value of shareholders’ wealth.
If managers have superior information on future input prices or investment
 P. Heu!y, S. Kung and K. Palepu, Accouniingprocedure changes and CEO compensation 33

opportunities, it would be costly for the compensation committee to determine

whether FIFO or LIFO, or accelerated or straight-line depreciation is ap-
propriate.16
The tests of the compensation-earnings relation indicate that there are
changes in the parameters of the relation for the test firms subsequent to an
accounting change. However, these changes seem to be at least in part due to
economy- and industry-wide changes which are unrelated to the accounting
changes. This conclusion is based on our finding that there are structural
changes in the compensation-earnings relation, and increases in salary and
bonus awards comparable to those of the test firms, for a matched sample of
control firms. We are unable to reject the hypothesis that CEOs in the test and
control firms have the same percentage increases in compensation in years
following the accounting changes.
.Our tests relating the changes in compensation model parameters of the test
firms to the effects of the accounting changes are inconclusive. We cannot
reject the hypothesis that the compensation committee nullifies the effect of an
accounting change on bonus and salary awards by modifying the parameters
of the compensation-earnings relation. We believe that this result is inconclu-
sive because the effect of the accounting change on compensation, as discussed
earlier, is too small compared to the time-related effects to allow us to
discriminate between the null and alternative hypotheses.
In summary, the potential decline in CEOs’ bonus and salary awards
following a change to LIFO is 2.3 percent per year. If compensation is not
adjusted for this method change, CEOs appear to switch to LIFO despite this
loss in their remuneration.” Similarly, the potential increase in CEOs’ bonus
and salary compensation due to the depreciation change is only about 1.5
percent per year. Thus, even if their remuneration is not adjusted for this
method change, the benefit to CEOs appears to be small.

lhSee Ball (1985) and Demski and Sappington (1985) for a discussion of selection of accounting
procedures when managers have inside information on the costs and benefits of alternative
accounting and production/investment decisions.
“There may be several reasons for this. The potential effect of the LIFO change on compensa-
tion may be overstated if firms in our sample have bonus plans with binding upper limits on
awards in the year of the inventory method change. As Biddle and Lindahl (1982) and Ricks
(1982) document, firms change to LIFO in years of large earnings increases. If there is an upper
limit on bonus awards, it is likely to be binding in these years under both FIFO and LIFO. Healy
(1985) finds that 46 percent of Fortune 250 industrial firms with usable bonus plans have an upper
limit on the pool of funds available for bonus awards. Also, managers own stock in the companies
that employ them. Their portfolio wealth will therefore i&crease following a change in LIFO if
equity prices reflect the accompanying tax savings. Finally, executives’ human capital is likely to
increase following a change to LIFO since the decision benefits shareholders.
34 P. He+, S. Kung und K. Palepy Accountingprocedure changes and CEO compensation

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